Two-bar reversals signal imminent pullback on Dow

L.A. Little, a professional money manager trading his own accounts while
managing investment funds for qualified investors, is the author of three books (Trade Like the Little Guy, Trend
Qualification and Trading, and Trend Trading Set-Ups) and has written extensively for many popular publications, such as Stocks and Commodities, Active Trader, TheStreet.com, RealMoneyPro.com and Minyanville.com. He writes daily on his website
Technical Analysis Today, which offers
tools and services that implement the concepts he espouses,
and can be reached at tat@tatoday.com.

Of the major indexes, the venerable Dow Jones Industrial Average pulled out the white flag Monday, signaling that an imminent reversal is now likely. Of the five major indexes, it was the only one to provide a test of the prior day’s high and fail on price and volume.

That, in and of itself, wouldn't be enough to concern me, but when I look at the 11 major sectors, seven of the 11 also triggered the same two-bar reversal failure. Seven of 11 is worth taking note of.

A plethora of two-bar reversals in the major sectors in an extended market is a clear warning sign that a retracement is not only likely, but highly probable. In fact, only one of the 11 remains bullish with partial failures on the others as well.

As background, a bullish two-bar reversal occurs when today's high exceeds the high of yesterday and then proceeds to close under the prior high with volume contraction and all of this comes after an extended move. The more extended the move, the better the signal. This one is quite extended.

The great thing about this reversal pattern is that, at worst, you usually get at least a pause, if not an immediate pullback, and many times the immediate retrace is what happens.

As an example, on Friday, the materials sector signaled a two-bar reversal. It was the first to do so. On Monday, volume expanded and prices slumped lower. Here's that chart.

Monday's sector reversals were everywhere, ranging from energy to consumer discretionary, from chips to utilities. Stocks move sectors and sectors move the markets. For this reason, unless the majority of these reversals fail, then I would expect the indexes to follow.

The next question is how much of a retrace is likely. If the target for the retrace isn't much, then why bother since the qualified trends for the market and sectors remain quite bullish on all time frames overall?

To arrive at a target, take a look at the S&P 500 and how it broke higher. Note that the breakout over 1474 was suspect. Realize that suspect trend transitions tend to fail more quickly than confirmed ones. Also recognize that the result of such a failure is a retest of the area where the breakout occurred. I call this retest and regenerate.

The idea is that price comes back to the scene of the crime and if higher price is in the cards, then the inability to break lower results in a regeneration of price higher. When the retest occurs, after six bars have passed the probability of regeneration higher increases dramatically, thus, even though a retrace is likely, the regeneration higher is also quite probable once the retrace plays out.

Looking at the S&P 500 chart, the 1474 area is the top of the retest and regenerate zone and is, thus, the target for the impending retrace.

Given all the above, the question to you is should you adjust your portfolio as a result of the changing conditions exhibited Monday in the market? For me, the answer is yes, but for you, it really depends on what you trying to do. If you are trading, then, sure, you should trade this setup since it represents a high-reward/low-risk, high-probability trading opportunity.

If you are investor, then, if anything, you lighten up a bit with the idea of adding more back on the retrace if it unfolds.

In you are a very long-term investor, you simply ignore the noise. If you are a fundamentalist, you probably say all of this is nonsense anyway and most likely won't get far enough to read this line.

As always, the answer of what one should do always depends on what one is trying to do. Regardless of what you are trying to do, the market is always talking about what it is trying to do and, from time to time, it tells you. Right now it is saying pullback — finally.

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